doughnut 2 circular flow

SEE THE BIG PICTURE

from self-contained market to embedded economy

For four hundred years, William Shakespeare’s plays have captivated theatre-goers worldwide, thanks to their unforgettable characters, gripping plots and poetic verse. To keep his actors on their toes, Shakespeare handed each member of the troupe only their own lines and cues to learn, intentionally leaving them in the dark about the unfolding plot. 1 Soon after his death, however, over-zealous editors added in complete lists of characters and, in plays such as The Tempest , introduced many parts along with their telltale traits: 2
PROSPERO, the right Duke of Milan
ANTONIO, his brother, the usurping Duke of Milan
GONZALO, an honest old counsellor
CALIBAN, a savage and deformed slave
STEFANO, a drunken butler
MIRANDA, daughter to Prospero
ARIEL, an airy spirit
Describe a character as an ‘usurping duke’ and the actors already suspect that past wrongs are waiting to be righted. Name another as ‘an honest old counsellor’ and they know his word is to be trusted. Introduce a third as a ‘drunken butler’ and they are waiting for the slapstick comedy. With such a character list, the play is pregnant with plot and the story ahead almost self-fulfilling.
What does this have to do with economics? Everything. ‘All the world’s a stage,’ Shakespeare famously wrote, ‘And all the men and women merely players.’ He had that right: today’s economic actors play out their roles on the international stage, and so enact the economic drama of our times. But who got to set that stage, who defined the telltale traits of the leading roles – and how can we now rewrite the story?
This chapter reveals the cast of characters, the script, and the playwrights behind the economic story that came to dominate the twentieth century – the one that has pushed us to the brink of collapse. But it also sets the stage for a twenty-first-century economic play – one whose characters and script can help bring us back, and into a thriving balance.
Economics may be theatre, but the play’s leading roles are never explicitly spelled out in the opening pages of the textbooks. Instead, the key characters are tacitly named through the most iconic diagram in macroeconomics, the Circular Flow. First drawn by Paul Samuelson, it was originally devised simply to illustrate how income flows round the economy. But it quickly came to define the economy itself, determining which economic actors were placed centre stage and which were shunted to the wings. Intentionally or not, Samuelson drew up the twentieth-century cast list. But it was his neoliberal rivals Friedrich Hayek and Milton Friedman who – just like Shakespeare’s editors – imbued each part with such telltale traits that the rest of the script almost wrote itself. In their resulting laissez-faire story of who the economy’s actors are and how best to let them work, the plot was loaded from the very start.
We are all well versed in its line-up of characters, having been told that the market is efficient, that trade is win–win, and that the commons are a tragedy. Given such a cast, the triumph of the market seems almost inevitable in the unfolding plot. However, we were all also told that finance is infallible – but that part of the story unravelled so publicly during the 2008 financial crash that even the scriptwriters had to admit it rang false. It has become increasingly clear that the neoliberal economic plot – in an ironic echo of The Tempest itself – has whipped us into a perfect storm of extreme inequality, climate change and financial crash.
These global crises have opened up a rare chance to rewrite the entire script and perform a new economic play. The place to begin is by revisiting the cast of characters who feature in the Circular Flow. It’s time to shake up macroeconomics – armed with nothing more than a pencil – by redrawing its most prized picture.
Setting the stage

When Samuelson launched his 1948 classic Economics , one of its many novel contributions was the Circular Flow diagram, which turned out to be a hit for teaching the masses. No wonder it has since spawned a million imitations, with a variation of it in almost every economics textbook.
As the first model of the macroeconomy that every economics student meets, this diagram gets the privileged ‘first lick’ of the beginner’s tabula rasa , as Samuelson so gleefully put it. So what message does this model convey about which actors count and which to ignore when it comes to economic analysis? Centre stage is the market relationship between households and business. Households supply their labour and capital in return for wages and profits, and then spend that income buying goods and services from firms. It is this interdependence of production and consumption that creates income’s circular flow. And that flow would be uninterrupted if it were not for three outer loops – involving commercial banks, government and trade – that divert some income for other uses. The model shows banks siphoning off income as savings and then returning it as investment. Government extracts income as taxes but re-injects it as public spending. Overseas traders need to be paid for the nation’s imports but in turn pay out for its exports. All three of these diversions create leakages from and injections into the market’s circular flow but, taken as a whole, the system is closed and complete – not unlike a circular set of plumbed pipes with water flowing round and round, as Samuelson first depicted it.
The Circular Flow diagram, which for 70 years was the defining depiction of the macroeconomy.
In fact the very year after Samuelson’s textbook was published, that likeness inspired an ingenious engineer-turned-economist, Bill Phillips, to construct such a hydraulic machine for real. His machine, known as the MONIAC (that’s short for Monetary National Income Analogue Computer), was made up of a set of see-through water tanks connected together by tubes flowing with pink water. Designed to bring the Circular Flow diagram to life, the MONIAC’s tanks and tubes represented the flow of income through the UK economy. It was the first computer model of an economy ever made and it was utterly brilliant, earning Phillips a teaching post at the London School of Economics. 3 But as a model it was also utterly flawed, as will become clear.
Bill Phillips and the MONIAC.
The engineers may have got carried away with the plumbed pipes, but the Circular Flow diagram deserves its credit because there are good reasons why it became a classic. The diagram was, for starters, the first attempt to depict the economy as a whole, and so helped to establish the field of macroeconomic modelling. Samuelson intended the diagram to illustrate Keynes’s insight into how economies can spiral into recession: if household spending starts to fall (say, due to fear of hard times ahead), then firms need fewer workers: as they lay staff off, they cut the nation’s take-home pay, so reducing demand even further. The result is a self-fulfilling recession, which – Keynes argued – could best be averted by boosting government spending until things got moving again and confidence was restored. What’s more, the diagram also provides the basis for different ways of measuring national income in an accounting framework that is still used worldwide. It is, evidently, a handy picture, making visible many key macroeconomic ideas.
The trouble, however, lies in what it leaves invisible. In the words of the systems thinker John Sterman, ‘The most important assumptions of a model are not in the equations, but what’s not in them; not in the documentation, but unstated; not in the variables on the computer screen, but in the blank spaces around them.’ 4 The Circular Flow diagram certainly needs to be introduced with this caveat. It makes no mention of the energy and materials on which economic activity depends, nor of the society within which those activities take place: they are simply missing from its cast of characters. Did Samuelson omit them on purpose? Unlikely: he was, after all, merely intent on illustrating the flow of income, and so they literally didn’t come into the picture. But with that, the stage was set.
Scripting the play

In 1947, the year before Samuelson published his iconic Circular Flow diagram, a small laissez-faire band of wannabe economic scriptwriters – including Friedrich Hayek, Milton Friedman, Ludwig von Mises and Frank Knight – gathered in the Swiss resort of Mont Pèlerin to start drafting what they hoped would one day become the dominant economic story. Inspired by the pro-market writings of classical liberals such as Adam Smith and David Ricardo they established what they called a ‘neoliberal’ agenda. Its aim, they said, was to push back hard against the threat of state totalitarianism, which was spreading fast thanks to the growing reach of the Soviet Union. But that aim gradually morphed into a hard push for market fundamentalism, and the meaning of ‘neoliberal’ morphed along with it. What’s more, when Paul Samuelson’s diagram appeared – depicting which actors were at the heart of the economy and which were pushed into the wings – it provided the perfect setting for their play.
Scriptwriting began in the late 1940s with the launch of the Mont Pelerin Society, which lives on to this day. 5 But Friedman, Hayek and the other hopeful playwrights knew they might have to wait some decades before their play could be performed. They took the long view: with backing from business and billionaires, they funded university professorships and scholarships, and built an international network of ‘free market’ think tanks, including the American Enterprise Institute and the Cato Institute in Washington, DC, and the Institute of Economic Affairs in London. 6
The big time came at last in 1980 when Margaret Thatcher and Ronald Reagan teamed up to bring the neoliberal script to the international stage. Both newly elected, they were surrounded by Mont Pelerin insiders: Reagan’s election team included more than twenty members of the Society, and Thatcher’s first Chancellor of the Exchequer, Geoffrey Howe, was a member too. Like the longest-running of Broadway shows, the neoliberal show has been playing ever since, powerfully framing the economic debate of the past thirty years. 7 It is high time we met the cast of characters that star in its story, each accompanied here by a biographical note and a one-line character summary that – in true Shakespearean style – loads the plot from the get-go.

Economics: the twentieth-century neoliberal story
(in which we go to the brink of collapse)

Staging by Paul Samuelson
Script by the Mont Pelerin Society

Cast, in order of appearance:

THE MARKET, which is efficient – so give it free rein. As Adam Smith famously wrote, ‘It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.’ 8 When the market’s invisible hand is set free to work its magic of allocative efficiency, it harnesses the self-interest of every household and business to provide all the goods and jobs that are wanted.

BUSINESS , which is innovative – so let it lead . ‘The business of business is business’ summed up Milton Friedman’s influential philosophy in the 1970s. Firms bring together labour and capital to produce novel goods and services and to maximise their profits. There is no need to look at what goes on in their factories and farms, so long as they play within the legal rules of the game.

FINANCE, which is infallible – so trust in its ways. Banks take people’s savings and dutifully turn them into profitable investments. Furthermore, according to Eugene Fama’s influential ‘efficient-market hypothesis’ of 1970, the price of financial assets always fully reflects all relevant information. 9 Hence financial markets are ever adjusting but always ‘right’ – and their smooth operation should not be distorted by regulation.

TRADE, which is win–win – so open your borders. David Ricardo’s nineteenth-century theory of comparative advantage demonstrates that countries should focus on what they are relatively good at doing and then trade: if they do, both parties will gain from it, no matter how unequal they are. 10 Hence trade barriers should be dismantled because they only distort the efficient workings of the international market.

THE STATE, which is incompetent – so don’t let it meddle. When government tries to intervene in the market, it usually makes things worse, distorting incentives and picking white elephants instead of winners. If it tries to smooth the business cycle, in classic Keynesian style, its timing will inevitably be off, and the market will pre-empt its effects. 11 Beyond defending the nation’s borders and its citizens’ private property, it is quite simply best for the state to leave things to the market.

Other characters not required on stage:

THE HOUSEHOLD, which is domestic – so leave it to the women. The household supplies labour and capital to the market, but there’s no need to lift the roof and ask what goes on within its four walls: wives and daughters kindly take care of domestic affairs and they belong in the home, as does this matter.

THE COMMONS, which are tragic – so sell them off. In the 1960s, Garrett Hardin described ‘the tragedy of the commons’ in which shared resources – such as grazing land and fish stocks – tend to be over-exploited by individual users and so are depleted for all. 12 Managing such resources sustainably therefore calls for government regulation or, better still, private ownership.

SOCIETY, which is non-existent – so ignore it. ‘There is no such thing as society,’ Margaret Thatcher famously declared in the 1980s. ‘There are individual men and women and there are families.’ 13 And it is, of course, the market that connects them, as workers and as consumers.

EARTH, which is inexhaustible – so take all you want. There will be no shortage of Earth’s resources, claimed the laissez-faire economist Julian Simon in the 1980s, if markets are permitted to do their job. A shortage of, say, copper or oil will raise its price, spurring people to use it more sparingly, search for new sources, and discover substitutes. 14

POWER, which is irrelevant – so don’t mention it. The only economic power to be worried about, argued Friedman, is monopoly power granted by the state when it meddles in the market, and the distortionary power of trade unions. The single best way to combat it is (no surprise) free markets and free trade. 15

It was, undeniably, a brilliant line-up – and almost a stitch-up. The market, promised the neoliberal script, is the road to freedom, and who could be against that? But putting blind faith in markets – while ignoring the living world, society, and the runaway power of banks – has taken us to the brink of ecological, social and financial collapse. It is time for the neoliberal show to leave the stage: a very different story is emerging.
A new century, a new show

To tell a new story let’s start with a new picture of the whole economy. Samuelson drew his iconic diagram in the late 1940s – in the wake of the Great Depression and the Second World War – and so was understandably focused on the question of how to get income flowing around the economy again. No wonder his diagram defined the economy in terms of its monetary flows alone. In doing so, however, it offered an extremely small stage for economic thinking, along with a stripped-down cast of characters. So let’s start afresh with an economic question better suited to our own times: what do we depend upon to provision for our needs? Here’s a visual answer to that question, summed up in a diagram that I have called The Embedded Economy, which brings into one picture important insights from diverse schools of economic thought. 16
The Embedded Economy, which nests the economy within society and within the living world, while recognising the diverse ways in which it can meet people’s needs and wants.
What does it show? First Earth – the living world – powered by energy from the sun. Within Earth is human society and, within that, economic activity, in which the household, the market, the commons and the state are all important realms of provisioning for human wants and needs, and are enabled by financial flows. If this diagram sets a new stage, then here is the cast of characters that it calls forth.

Economics: the twenty-first-century story
(in which we create a thriving balance)

Staging and script: a work in progress by economic re-thinkers everywhere

Cast in order of appearance:
EARTH, which is life-giving – so respect its boundaries
SOCIETY, which is foundational – so nurture its connections
THE ECONOMY, which is diverse – so support all of its systems
THE HOUSEHOLD, which is core – so value its contribution
THE MARKET, which is powerful – so embed it wisely
THE COMMONS, which are creative – so unleash their potential
THE STATE, which is essential – so make it accountable
FINANCE, which is in service – so make it serve society
BUSINESS, which is innovative – so give it purpose
TRADE, which is double-edged – so make it fair
POWER, which is pervasive – so check its abuse
What follows is a biography for each of these parts – longer than the twentieth-century ones because these new roles are not yet nearly so familiar. It is time to meet the twenty-first century’s economic actors anew.
EARTH, which is life-giving – so respect its boundaries

Far from floating against a white background, the economy exists within the biosphere, that delicate living zone of Earth’s land, waters and atmosphere. And it continually draws in energy and matter from Earth’s materials and living systems, while expelling waste heat and matter back out into it. Everything that is produced – from clay bricks to Lego blocks, websites to construction sites, liver pâté to patio furniture, single cream to double glazing – depends upon this through-flow of energy and matter, from biomass and fossil fuels to metal ores and minerals. None of this is news. But if the economy is so evidently embedded in the biosphere, how has economics so blatantly ignored it?
Earth’s importance for the economy was self-evident to the early economists. In the eighteenth century, François Quesnay and his fellow Physiocrats took their name from their belief that agrarian land was the key to understanding economic value. Yes, these early economists based their ecological thinking narrowly on agricultural land alone, but at least the living world got a mention. From there, however, things began to go awry, and there are many theories as to why.
Adam Smith, father of classical economic thinking, drew on the Physiocrats’ work, believing that a nation’s potential for wealth ultimately depended upon its climate and soil. But he also thought that the secret to productivity lay in the division of labour and so focused his attention on that. David Ricardo likewise believed that the ‘original and indestructible powers of the soil’ made scarce agricultural land a key determinant of economic value. 17 But as new lands were cultivated in Britain’s colonies, he decided that land scarcity was no longer such a threat and so, like Smith, switched his attention to labour instead. John Stuart Mill also clearly saw the importance of Earth’s materials and energy in all economic production, but he wanted to distinguish social science from natural science and so (rather unhelpfully) proposed that the field of political economy focus on the laws of the mind, not the laws of matter. 18 In the 1870s the radical American thinker Henry George pointed out that land gained value for its owners even if they did nothing to improve it, and so he advocated a land-value tax – prompting his influential (and land-owning) opponents to downplay the importance of land in economic theory from then on. 19
The upshot of all this? The classical economists, led by Smith and Ricardo, had recognised labour, land and capital as three distinct factors of production. But by the late twentieth century, mainstream economics had reduced the focus to just two: labour and capital – and if ever land did get a mention, it was as just another form of capital, interchangeable with all the rest. 20 As a result, mainstream economics is still taught today with scant attention paid to the living planet that supports us and the blazing star whose energy we depend upon. 21 It relegates ecological stresses such as climate change, deforestation, and soil degradation to the periphery of economic thought, until they become so severe that their damaging economic impacts demand attention.
So let’s restore sense from the outset and recognise that, far from being a closed, circular loop, the economy is an open system with constant inflows and outflows of matter and energy. The economy depends upon Earth as a source – extracting finite resources like oil, clay, cobalt and copper, and harvesting renewable ones like timber, crops, fish and fresh water. The economy likewise depends upon Earth as a sink for its wastes – such as greenhouse gas emissions, fertiliser run-off, and throwaway plastics. Earth itself, however, is a closed system because almost no matter leaves or arrives on this planet: energy from the sun may flow through it, but materials can only cycle within it. 22
Redrawing the economy as an open subsystem of the closed Earth system is the major conceptual shift introduced by ecological economists such as Herman Daly in the 1970s. And it’s a paradigm shift that has become increasingly important, given the economy’s ever-growing scale. When Adam Smith published The Wealth of Nations in 1776, there were fewer than one billion people alive and, in dollar terms, the size of the global economy was 300 times smaller than it is today. When Paul Samuelson published Economics in 1948 there were not yet three billion people on Earth and the global economy was still ten times smaller than it is today. In the twenty-first century we have left behind the era of ‘Empty World’, when the flow of energy and matter through the global economy was small in relation to the capacity of nature’s sources and sinks. We live now, says Daly, in ‘Full World’, with an economy that exceeds Earth’s regenerative and absorptive capacity by over-harvesting sources such as fish, and forests, and over-filling sinks such as the atmosphere and oceans. 23
To this add a second shift in perspective: the economy’s fundamental resource flow is not a roundabout of money but, rather, a one-way street of energy – and nothing can move, grow or work without using that energy. This is where Bill Phillips’s MONIAC machine was fundamentally flawed. While brilliantly demonstrating the economy’s circular flow of income, it completely overlooked its throughflow of energy. To make his hydraulic computer start up, Phillips had to flip a switch on the back of it to turn on its electric pump. Like any real economy it relied upon an external source of energy to make it run, but neither Phillips nor his contemporaries spotted that the machine’s power source was a critical part of what made the model work. That lesson from the MONIAC applies to all of macroeconomics: the role of energy deserves a far more prominent place in economic theories that hope to explain what drives economic activity.
The vast majority of energy that powers today’s global economy is from the sun. Some of that solar energy, such as sunshine and wind, arrives in real time each day. Some has been stored in recent times, like the energy bound up in crops, livestock and trees. And some has been stored up since ancient times, particularly the fossil fuels of oil, coal and gas. Which of these sources of solar energy the economy uses matters a great deal, and here’s why. It was thanks to the balance between real-time solar energy entering Earth’s atmosphere and heat escaping back out into space that Earth maintained a steady and benevolent average temperature during the Holocene. Over the past 200 years, however, and especially since 1950, humanity’s use of ancient fossil-fuel energy has released carbon dioxide and other greenhouse gases into the atmosphere at an entirely unprecedented rate, with potentially dangerous consequences. Most of these gases occur naturally in the atmosphere and, together with water vapour, act like a blanket around the Earth, keeping its surface much warmer than it otherwise would be. Releasing more carbon dioxide, however, thickens that blanket and so further raises Earth’s temperature, resulting in human-induced global warming. 24
This wider perspective of the throughflow of energy and materials invites us to imagine the economy as a super-organism – think giant slug – that demands a continual intake of matter and energy from Earth’s sources, and delivers a continual stream of waste matter and waste heat into its sinks. On a planet with intricately structured ecosystems and a delicately balanced climate, this begs a now obvious question: how big can the global economy’s throughflow of matter and energy be in relation to the biosphere before it disrupts the very planetary life-support systems on which our well-being depends? The nine planetary boundaries give a compelling first answer to that question and in Chapter 6 we will explore just how the economy’s use of matter and energy can be redesigned so that it works with, not against, the cycles of life that those boundaries seek to protect.
SOCIETY, which is foundational – so nurture its connections

When Thatcher declared that there is no such thing as society, it came as a surprise to many – not least to society. Political theorists such as Robert Putnam use the term ‘social capital’ to describe the wealth of trust and reciprocity that is created within social groups as a result of their networks of relationships. 25 Whether through local sports teams or international festivals, faith groups or social clubs, we build norms, rules and relations that enable us to cooperate with and depend upon one another. These connections build social cohesion and help to meet our fundamental human needs such as for participation, leisure, protection and belonging. ‘Community connectedness is not just about warm fuzzy tales of civic triumph,’ writes Putnam; ‘In measurable and well-documented ways … social capital makes us smarter, healthier, safer, richer, and better able to govern a just and stable democracy.’ 26
It’s clear that an economy’s vibrancy depends upon the trust, norms and sense of reciprocity nurtured within society – just as every sport depends upon its players abiding by a shared set of rules. But a society’s vibrancy is, in turn, shaped by the structure of its economy: the relationships that it builds or weakens; the public spirit that it fosters or erodes; and the distribution of wealth that it generates, as Chapter 5 explores.
A thriving society, in addition, is more likely to build strong political engagement, starting with community meetings, grassroots organising, voting in elections, and joining social and political movements that hold political representatives to account. ‘Significant changes occur when social movements reach a critical point of power capable of moving cautious politicians beyond their tendency to keep things as they are,’ writes the American historian Howard Zinn, pointing to his own country’s nineteenth-century anti-slavery movement and twentieth-century civil rights movement. 27 Democratic governance of society and the economy rests on the right and capacity of citizens to engage in public debate – hence the importance of ‘political voice’ within the Doughnut’s social foundation.
THE ECONOMY, which is diverse – so support all of its systems

Embedded within this rich web of society is the economy itself, the realm in which people produce, distribute and consume products and services that meet their wants and needs. One basic feature of the economy is rarely pointed out in Econ 101: that it is typically made up of four realms of provisioning: the household, the market, the commons and the state, as shown in the Embedded Economy diagram. All four are means of production and distribution, but they go about it in very different ways. Households produce ‘core’ goods for their own members; the market produces private goods for those willing and able to pay; the commons produce co-created goods for the communities involved; and the state produces public goods for all the populace. I wouldn’t want to live in a society whose economy lacked any of these four realms of provisioning because each one has distinct qualities and much of their value arises through their interactions. In other words, they work best when they work together.
What’s more, while the Circular Flow diagram identified people primarily as workers, consumers and capital owners, the Embedded Economy diagram invites us to acknowledge our many other social and economic identities. In the household we may be parents, carers and neighbours. In relation to the state we are members of the public, using public services and paying taxes in return. In the commons we are collaborative creators and stewards of shared wealth. In society we are citizens, voters, activists and volunteers. Every day we switch almost seamlessly between these different roles and relations: from customer to creator, from marketplace to meeting space, from bargaining to volunteering. So let’s consider each realm in turn.
THE HOUSEHOLD, which is core – so value its contribution

The Circular Flow diagram depicted labour appearing – hey presto! – fresh and ready for work each day at the office or factory door. So who cooked, cleaned up, and cleared away to make that possible? When Adam Smith, extolling the power of the market, noted that, ‘it is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner’, he forgot to mention the benevolence of his mother, Margaret Douglas, who had raised her boy alone from birth. Smith never married so had no wife to rely upon (nor children of his own to raise). At the age of 43, as he began to write his opus, The Wealth of Nations , he moved back in with his cherished old mum, from whom he could expect his dinner every day. But her role in it all never got a mention in his economic theory, and it subsequently remained invisible for centuries. 28
As a result, mainstream economic theory is obsessed with the productivity of waged labour while skipping right over the unpaid work that makes it all possible, as feminist economists have made clear for decades. 29 That work is known by many names: unpaid caring work, the reproductive economy, the love economy, the second economy. However, as economist Neva Goodwin has pointed out, far from being secondary, it is actually the ‘core economy’ and it comes first every day, sustaining the essentials of family and social life with the universal human resources of time, knowledge, skill, care, empathy, teaching and reciprocity. 30 And if you have never really thought of it before, then it’s time you met your inner housewife (because we all have one). She lives in the daily dealings of making breakfast, washing the dishes, tidying the house, shopping for groceries, teaching the children to walk and to share, washing clothes, caring for elderly parents, emptying the rubbish bins, collecting kids from school, helping the neighbours, making the dinner, sweeping the floor, and lending an ear. She carries out all those tasks – some with open arms, others through gritted teeth – that underpin personal and family well-being and sustain social life.
We all have a hand in this core economy, but some people (like Adam Smith’s mum) spend far more time in it than others. Time may be a universal human resource but it varies hugely in terms of how we each get to experience and use it, how far we control it, and how it is valued. 31 In sub-Saharan Africa and South Asia, time spent in the core economy is particularly visible because, when the state fails to deliver and the market is out of reach, householders have to make provision for many more of their needs directly. Millions of women and girls spend hours walking miles each day, carrying their body weight in water, food or firewood on their heads, often with a baby strapped to their back – and all for no pay. But this gendered division of paid and unpaid work is prevalent in every society, albeit sometimes less visibly so. And since work in the core economy is unpaid, it is routinely undervalued and exploited, generating lifelong inequalities in social standing, job opportunities, income, and power between women and men.
By largely ignoring the core economy, mainstream economics has also overlooked just how much the paid economy depends upon it. Without all that cooking, washing, nursing and sweeping, there would be no workers – today or in the future – who were healthy, well-fed, and ready for work each morning. As the futurist Alvin Toffler liked to ask at smart gatherings of business executives, ‘How productive would your workforce be if it hadn’t been toilet trained?’ 32 The scale of the core economy’s contribution is not to be dismissed lightly, either. In a 2002 study of Basle, a wealthy Swiss city, the estimated value of unpaid care being provided in the city’s households exceeded the total cost of salaries paid in all of Basle’s hospitals, daycare centres and schools, from the directors to the janitors. 33 Likewise, a 2014 survey of 15,000 mothers in the USA calculated that, if women were paid the going hourly rate for each of their roles – switching between housekeeper and daycare teacher to van driver and cleaner – then stay-at-home mums would earn around $120,000 each year. Even mothers who do head out to work each day would earn an extra $70,000 on top of their actual wages, given all the unpaid care they also provide at home. 34
Why does it matter that this core economy should be visible in economics? Because the household provision of care is essential for human well-being, and productivity in the paid economy depends directly upon it. It matters because when – in the name of austerity and public-sector savings – governments cut budgets for children’s daycare centres, community services, parental leave and youth clubs, the need for care-giving doesn’t disappear: it just gets pushed back into the home. The pressure, particularly on women’s time, can force them out of work and increase social stress and vulnerability. That undermines both well-being and women’s empowerment, with multiple knock-on effects for society and the economy alike. In short, including the household economy in the new diagram of the macroeconomy is the first step in recognising its centrality, and in reducing and redistributing women’s unpaid work. 35
THE MARKET, which is powerful – so embed it wisely

Adam Smith’s great insight was to show that the marketplace can mobilise diffuse information about people’s wants and the cost of meeting them, thereby coordinating billions of buyers and sellers through a global system of prices – all without the need for a centralised grand plan. This distributed efficiency of the market is indeed extraordinary, and attempting to run an economy without it typically leads to short supplies and long queues. It was out of recognition of this power that the neoliberal scriptwriters put the market centre stage in their economic play. There is, however, a flip side to the market’s power: it only values what is priced and only delivers to those who can pay. Like fire, it is extremely efficient at what it does, but dangerous if it gets out of control. When the market is unconstrained, it degrades the living world by over-stressing Earth’s sources and sinks. It also fails to deliver essential public goods – from education and vaccines to roads and railways – on which its own success deeply depends. At the same time, as Chapter 4 will show, its inherent dynamics tend to widen social inequalities and generate economic instability. That is why the market’s power must be wisely embedded within public regulations, and within the wider economy, in order to define and delimit its terrain.
It is also why, whenever I hear someone praising the ‘free market’, I beg them to take me there, because I’ve never seen it at work in any country that I have visited. Institutional economists – from Thorstein Veblen to Karl Polanyi – have long pointed out that markets (and hence their prices) are strongly shaped by a society’s context of laws, institutions, regulations, policies and culture. As Ha-Joon Chang writes, ‘A market looks free only because we so unconditionally accept its underlying restrictions that we fail to see them.’ 36 From passports to medicines and AK-47s, many things cannot be legally bought or sold without official licence. Trade unions, immigration policies, and minimum wage laws all have an effect on a country’s going wage rate. Company reporting requirements, the culture of shareholder primacy, and state-funded bailouts all influence the level of corporate profits. Forget the free market: think embedded market. And, strange though it sounds, that means there is no such thing as deregulation, only reregulation that embeds the market in a different set of political, legal and cultural rules, simply shifting who bears the risks and costs and who reaps the gains of change. 37
THE COMMONS, which are creative – so unleash their potential

The commons are shareable resources of nature or society that people choose to use and govern through self-organising, instead of relying on the state or market for doing so. Think of how a village community might manage its only freshwater well and its nearby forest, or how Internet users worldwide collaboratively curate Wikipedia. Natural commons have traditionally emerged in communities seeking to steward Earth’s ‘common pool’ resources, such as grazing land, fisheries, watersheds and forests. Cultural commons serve to keep alive a community’s language, heritage and rituals, myths and music, traditional knowledge and practice. And the fast-growing digital commons are stewarded collaboratively online, co-creating open-source software, social networks, information and knowledge.
Garrett Hardin’s description of the commons as ‘tragic’ – which fitted so neatly into the neoliberal script – arose from his belief that, if left as open access to all, then pastures, forests and fishing grounds would inevitably be overused and depleted. He was most probably right about that, but ‘open access’ is far from how successful commons are actually governed. In the 1970s, the little-known political scientist Elinor Ostrom started seeking out real-life examples of well-managed natural commons to find out what made them work – and she went on to win a Nobel-Memorial prize for what she discovered. Rather than being left ‘open access’, those successful commons were governed by clearly defined communities with collectively agreed rules and punitive sanctions for those who broke them. 38 Far from tragic, she realised, the commons can turn out to be a triumph, outperforming both state and market in sustainably stewarding and equitably harvesting Earth’s resources, as Chapters 5 and 6 illustrate.
The triumph of the commons is certainly evident in the digital commons, which are fast turning into one of the most dynamic arenas of the global economy. It is a transformation made possible, argues the economic analyst Jeremy Rifkin, by the ongoing convergence of networks for digital communications, renewable energy and 3D printing, creating what he has called ‘the collaborative commons’. What makes the convergence of these technologies so powerfully disruptive is their potential for distributed ownership, networked collaboration, and minimal running costs. Once the solar panels, computer networks and 3D printers are in place, the cost of producing one extra joule of energy, one extra download, one extra 3D printed component, is close to nothing, leading Rifkin to dub it ‘the zero-marginal-cost revolution’. 39
The result is that a growing range of products and services can be produced abundantly, nearly for free, unleashing potential such as open-source design, free online education, and distributed manufacturing. In some key sectors the twenty-first-century collaborative commons has started to complement, compete with, and even displace the market. What’s more, the value generated is enjoyed directly by those who co-create in the commons, and it may never be monetised – with intriguing implications for the future of GDP growth, as Chapter 7 explores.
Despite their creative potential – and sometimes because of it – the commons have, for centuries, been encroached upon by the market and the state alike, through the enclosure of common land, the division of enterprise into workers and owners, and the rise of market-versus-state rivalry. All of this was aided by economic theory which purported to show that the commons were doomed to fail. But, thanks to Ostrom, widely documented evidence of success in the commons has generated growing interest in their resurgence – and that is why they must be drawn clearly into the Embedded Economy diagram.
THE STATE, which is essential – so make it accountable

As lead author of the neoliberal script, Milton Friedman was determined to limit the state’s economic role to defending the nation, policing its streets, and enforcing its laws. Its legitimate purpose, he believed, was simply to secure private property and legal contracts, which he saw as the prerequisites for smoothly functioning markets. 40 In effect, he sought to relegate the state to a non-speaking part in the economic play: mentioned in the storyline, seen fleetingly on stage, but permitted little action. His rival, Paul Samuelson, strongly disagreed with that view. ‘The creative role of government in economic life is vast and inescapable in an interdependent and crowded world,’ he wrote in later editions of his textbook, but Friedman’s stance still prevailed among those keen to ‘roll back’ the state. 41
For the twenty-first-century economic story, the state’s role must be rethought. Put it this way: in the film of the play, the state should be aiming all-out to win Best Supporting Actor at the Oscars – starring as the economic partner that supports the household, the commons and the market alike. First, by providing public goods – ranging from public education and healthcare to roads and street lighting – that deliver for all, not just for those who can pay, so enabling a society and its economy to thrive. Second, by supporting the core caring role of the household, such as with maternal and paternal leave policies that empower both parents, investment in early-years education, and care support for seniors. Third, by unleashing the dynamism of the commons, with laws and institutions that enable their collaborative potential and protect them from encroachment. Fourth, by harnessing the power of the market by embedding it in institutions and regulations that promote the common good – from banning toxic pollutants and insider trading to protecting biodiversity and workers’ rights.
Like all best supporting actors, the state may also step centre stage, taking entrepreneurial risks where the market and commons can’t or won’t reach. The extraordinary success of tech companies like Apple is sometimes held up as evidence of the market’s dynamism. But Mariana Mazzucato, an expert in the economics of government-led innovation, points out that the basic research behind every innovation that makes a smart phone ‘smart’ – GPS, microchips, touchscreens, and the Internet itself – was funded by the US government. The state, not the market, turns out to have been the innovating, risk-taking partner, not ‘crowding out’ but ‘dynamising in’ private enterprise – and this trend holds across other high-tech industries too, such as pharmaceuticals and biotech. 42 In the words of Ha-Joon Chang, ‘If we remain blinded by the free market ideology that tells us only winner-picking by the private sector can succeed, we will end up ignoring a huge range of possibilities for economic development through public leadership or public-private joint efforts.’ 43 Such state leadership is now needed worldwide to catalyse public, private, commons and household investments in a renewable energy future.
The state as empowering, enabling economic partner: it sounds so good – is it too good to be true? That crucially depends, argue the economist Daron Acemoglu and political scientist James Robinson, on whether, in each country, the state’s economic and political institutions are inclusive or extractive. Put simply, inclusive institutions give many people a say in decision-making, unlike extractive ones that privilege the voice of the few and allow them to exploit and rule over others. 44 The threat of the authoritarian state is very real, but so too is the danger of market fundamentalism. To avoid the tyranny of the state and the tyranny of the market alike, democratic politics are key – thus reinforcing the foundational role played by society in generating the civic engagement needed for participation and accountability in public and political life.
FINANCE, which is in service – so make it serve society

Three long-held myths make up the traditional story of finance: that commercial banks work by turning people’s savings into investments; that financial trading smoothes out the economy’s fluctuations; and that, therefore, the financial sector provides a valuable service to the productive economy. All three of these myths were busted very publicly by the 2008 financial crisis. Far from simply lending out savings, banks magically create money as credit. Far from promoting stability, financial markets inherently generate flux. And far from providing a valuable service to the productive economy, finance has turned into the tail that wags the dog.
First, contrary to the textbook story and the Circular Flow diagram, banks do not merely lend out the money that has been deposited by their savers. They create money from nothing each time they issue loans – recording on their books both a liability (since the loan is withdrawn by the borrower) and a credit (since the loan will be repaid with interest over time). Such credit creation is hardly new – it started several thousand years ago – and it can play a valuable role, but it has grown hugely in scale since the 1980s. That expansion was triggered by financial deregulation (think re regulation) – including the 1986 Big Bang in the UK and the 1999 repeal of the Glass–Steagall Act in the US – which ended the requirement for banks to keep customers’ savings and loans separate from their own speculative investments.
Second, financial markets do not tend to promote economic stability, despite the claims that they do. Thanks to financial deregulation, said US Federal Reserve Chair Alan Greenspan in 2004, ‘not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.’ 45 Four years later, the financial crash disproved that claim in a fairly decisive way. At the same time, Eugene Fama’s efficient-market hypothesis – that financial markets are inherently efficient – lost credibility and has been countered by Hyman Minsky’s financial-instability hypothesis – that financial markets are inherently volatile – as we will see in Chapter 4 .
Lastly, far from playing a supporting role to the productive economy, finance has come to dominate it. In many countries, a small financial elite – based in just a handful of banking and financial firms – controls the public good of money creation and profits handsomely from it, while too often destabilising much of the wider economy in the process. It is time to turn this upside-down scenario the right way up and redesign finance so that it flows in service of the economy and society. Such a redesign also invites a rethink of how money could be created – not just by the market but by the state and the commons too – and Chapters 5 , 6 and 7 explore some possibilities for that.
BUSINESS, which is innovative – so give it purpose

Operating within the realm of the market, business can be extraordinarily effective in combining people, technology, energy, materials and finance to create something new. The neoliberal narrative claimed that the market mechanism is what makes firms efficient, and so ignored what goes on inside them, just as it did with the household. But it is essential to lift the lid here too and look inside the black box of production.
Power is always at play between a firm’s waged workers and its shareholding owners because of the vast inequalities between them, as Friedrich Engels and Karl Marx witnessed in the squalid factories of Victorian Britain. Such conditions can still be found in factories and farms across the world today where, in the name of profit, managers routinely flout the law, for example by locking workers in, banning toilet breaks, or sacking women if they become pregnant. But even when businesses operate within the law they can, in many countries, hire workers on insecure, zero-hour contracts, while paying a legal minimum wage that leaves them living below the poverty line. 46
Ensuring workers’ rights to organise and bargain collectively is one way of offsetting such deep power imbalances: another is to change the ownership structure of the firm itself, ending the centuries-old divide between workers and owners, as Chapter 5 explores. What’s more, Friedman’s narrow view on the business of business has lost credibility: in the face of twenty-first-century challenges, firms need a purpose far more inspiring than merely maximising shareholder value and, as Chapter 6 illustrates, a growing number of enterprises are finding ways to give themselves one.
TRADE, which is double-edged – so make it fair

The Embedded Economy diagram could be used to depict a single nation’s economy, but it can likewise portray the global economy, and so includes international trade. Globalisation has led to the rapid expansion of cross-border flows in the last 20 years, thanks to shipping containers and the Internet slashing the costs of international transport and communications and, since 1995, thanks to the World Trade Organization’s agenda of trade liberalisation.
Ricardo’s influential theory of win–win trade was based on products like wine and cloth, and assumed that the factors of production – land, labour and capital – were immovable behind national borders. Today, everything but land moves, with cross-border flows including trade in products and services (from fresh fruit to legal advice); foreign direct investment (in businesses and properties); financial flows (from bank loans to corporate stocks), and the migration of people in search of a livelihood.
All of these cross-border flows have the potential to deliver benefits but they carry risks, too. When it is cheaper to import staple foods like rice and wheat than it is to grow them, trade can significantly reduce food prices for consumers. At the same time it may undermine domestic food production and leave the country highly vulnerable to international price hikes – as bread riots from Egypt to Burkina Faso revealed when the global price of wheat, corn and rice trebled during the food price crisis of 2007–8. When skilled workers migrate – such as doctors and nurses from sub-Saharan Africa working in Europe – they bring valuable skills and send much-needed remittances to their families back home, but this can also lead to a skill shortage in their own country’s core services. When corporations offshore manufacturing, it often delivers cheaper products to consumers and creates new jobs overseas. But it can also result in domestic job losses that decimate whole communities – as experienced in America’s ‘rust belt’, the nation’s former industrial heartland. Likewise, financial inflows may boost an emerging economy’s fledgling stock market but when international finance exits even faster than it entered, it can induce a near collapse of the currency, as Thailand, Indonesia and South Korea discovered the hard way during the Asian financial crisis of the late 1990s. Cross-border flows are always double-edged and so need to be managed.
Ricardo was right in thinking that very different nations may be able to trade to mutual gain, but comparative advantage is not only what you are blessed with: it is something you can build. As Ha-Joon Chang puts it, however, today’s high-income countries are ‘kicking away the ladder’ that they once climbed, recommending that low- and middle-income countries open their borders to follow a trade strategy that they strategically avoided themselves. Despite their current rhetoric of ‘free trade’, when it comes to trade negotiations almost all of today’s high-income countries – including the UK and the US – took the opposite route to ensure their own industrial success, opting for tariff protection, industrial subsidies and state-owned enterprises when it was nationally advantageous. And today they still keep tight control over their key traded assets such as intellectual property. 47
Just as there is no such thing as the free market, it turns out that there is no such thing as free trade: all cross-border flows are set against the backdrop of national history, current institutions and international power relations. As the world’s 2007–8 food price crisis followed by the 2008–10 financial crisis illustrated, it requires effective cooperation among governments to make sure that the benefits of cross-border flows are widely shared.
POWER, which is pervasive – so check its abuse

Search for the word ‘power’ in the index of a modern economics textbook and – if mentioned at all – it will probably refer you to an analysis of electricity sector reform. But power is at play in myriad places throughout the economy and society: in daily household decisions about who cares for the kids; in boss-versus-worker wage negotiations; in international trade and climate-change talks; and in humanity’s domination over other species on the planet. Wherever people are present, so too are power relations: think of them as running throughout the Embedded Economy diagram, within each of its domains and at the interface between them too.
Out of all of these power relationships, when it comes to the workings of the economy, one in particular demands attention: the power of the wealthy to reshape the economy’s rules in their favour. Samuelson’s Circular Flow diagram inadvertently helped to gloss over this matter by depicting households as a homogeneous group, each one offering its labour and capital in return for wages and a share of profits – which are, in turn, paid out by a cluster of homogeneous firms. But, as the Occupy Movement made clear with its meme of the 1% and the 99%, that stylised picture doesn’t quite do justice to the reality we have come to know. Inequality amongst households and firms alike has soared in many countries in recent decades. And the extreme concentration of income and wealth – in the hands both of billionaires and of corporate boards – rapidly turns into power over how and for whom the economy is run.
In politics, money talks – when it must in public, but preferably in private, with hidden handshakes, closed-door meetings, and under-the-table kickbacks. These relationships obey a powerful ‘golden rule’, says the political scientist Thomas Ferguson, based on his long analysis of US political funding. Business effectively invests in political candidates and expects a return on that investment in the form of favourable policies. ‘To discover who rules, follow the gold,’ he advises: trace the finance backing any major political campaign and you’ll see what drives its policies. 48
In the US, private and corporate funding for elections has increased more than twentyfold since 1976, and it topped $2.5 billion during the 2012 Obama–Romney presidential race. 49 Since 2005, the fossil-fuel industry alone has spent $1.7 billion in the USA on lobbying and campaign contributions, which explains their entrenched political support. In Europe, the EU–US Transatlantic Trade and Investment Partnership (TTIP) – a proposed trade treaty promising private court hearings for American and European corporations wishing to sue each other’s governments – was drawn up under the heavy influence of big business. In 2012–13, as treaty discussions got under way, over 90% of meetings held by the European Union – 520 out of 560 – were with corporate lobbyists. 50 Such examples simply add to the reasons why, in the twenty-first-century story, the economy must be designed to be far more distributive not just of income but also of wealth, as Chapter 5 explores, in order to counter elite power with citizens’ empowerment.
Raising the curtain on a twenty-first-century story

Stand back, survey the whole stage and the new cast of characters that this chapter has introduced: what difference does it all make? Simply putting aside the Circular Flow diagram and drawing the Embedded Economy instead transforms the starting point of economic analysis. It ends the myth of the self-contained, self-sustaining market, replacing it with provisioning by the household, market, commons and state – all embedded within and dependent upon society, which in turn is embedded within the living world. It shifts our attention from merely tracking the flow of income to understanding the many distinct sources of wealth – natural, social, human, physical and financial – on which our well-being depends.
This new vision prompts new questions. Instead of immediately focusing on making markets work more efficiently, we can start by considering: when is each of the four realms of provisioning – household, commons, market and state – best suited to delivering humanity’s diverse wants and needs? What changes in technology, culture and social norms might alter that? How can these four realms most effectively work together – such as the market with the commons, the commons with the state, or the state with the household? Likewise, rather than focusing by default on how to increase economic activity, ask how the content and structure of that activity might be shaping society, politics and power. And just how big can the economy become, given Earth’s ecological capacity?

At the end of Shakespeare’s Tempest – when all wrongs have been righted – Prospero’s daughter Miranda, who has lived a cloistered life on the island with her father, sees for the first time the scheming noblemen of Milan who were shipwrecked by the storm. ‘Oh, wonder!’ she exclaims, ‘How many goodly creatures are there here! How beauteous mankind is! O brave new world / That has such people in’t!’ Twenty-first-century economists might share her wonder, but without her political naivety. Having been cloistered for seventy years within the confines of Samuelson’s insular Circular Flow diagram and the Mont Pelerin Society’s narrow neoliberal script, we can now start writing a new story simply by picking up a pencil and first drawing the Embedded Economy. And since this big-picture perspective puts the economy in context, it is far easier to see some of the big questions that the twenty-first-century economist must tackle. There’s just one thing still missing and that is the play’s protagonist: humanity.